The Dollar Explained: DXY, Rates and Why It Moves Markets

The dollar index is six currencies wide. More than half of it is the euro. The gauge quoted in every market report as the strength of the dollar therefore tells you a great deal about the euro, a fair amount about the yen and the pound, and almost nothing about the dollar against the currencies of the countries the United States does the most trade with.

That is worth knowing before anything else, because the index gets read as a verdict on the currency and it was built to answer a narrower question than the one people ask of it.

What the index is made of

The ICE US Dollar Index began in March 1973 at a base of 100, shortly after the fixed exchange rate system agreed at Bretton Woods came apart and the major currencies were left to float against each other. It has been revised once. In 1999 the German mark, French franc, Italian lira, Dutch guilder and Belgian franc were replaced by the single currency that had absorbed them, and the weights have sat untouched ever since.

Currency	Weight
Euro	57.6%
Japanese yen	13.6%
British pound	11.9%
Canadian dollar	9.1%
Swedish krona	4.2%
Swiss franc	3.6%

Read that table twice. The Swedish krona carries more weight than the Swiss franc. Mexico, China and South Korea do not appear at all, despite being among the largest trading partners the United States has, and the index has never been adjusted to reflect any of the enormous changes in the direction of American trade over the decades since the weights were set, which is the sort of thing that happens when a benchmark becomes too widely quoted to change.

The calculation is a geometric weighted average of the six exchange rates. A move in the euro dominates the result. When a headline says the dollar rallied, it usually means the euro fell.

Which way is up

One convention causes more confusion than everything else in this subject combined. A currency pair is quoted as the price of the first currency expressed in the second.

EURUSD at 1.1000 means one euro buys 1.10 dollars, so when that number rises the euro has strengthened and the dollar has weakened. USDJPY at 150 means one dollar buys 150 yen, and a rise there means the dollar has strengthened. The dollar sits on the left of some pairs and on the right of others, purely by market habit, and traders will describe the euro going up when they mean the same event a dollar index chart is showing as a line going down.

The index itself is built so that a rising line means a stronger dollar. Currency moves get quoted in one direction and felt in the other, which is why it pays to write down which side of the pair you are on before doing any arithmetic at all.

Rate differentials do most of the work

Money goes where it is paid more, adjusted for what it costs to get back. That single sentence explains most of the day-to-day action in currencies, and the arbitrage that enforces it can be written down exactly.

Suppose the euro buys 1.1000 dollars today. One year dollar rates are 4% and one year euro rates are 2%. A trader can hold dollars at 4%, or convert to euros, earn 2% and sell the euros forward at a price agreed this morning, and since those two paths have to finish in the same place the forward price of the euro is:

1.1000 x (1.04 / 1.02) = 1.1216

Check it. Take $1.10, buy one euro, earn 2% to finish with 1.02 euros, and sell them forward at 1.1216 for 1.02 x 1.1216 = $1.1441, which is what $1.10 at 4% would have produced anyway. The lower yielding currency trades at a premium in the forward market. That premium exactly cancels the interest advantage of the higher yielding one, leaving no free money anywhere in the arrangement, which is why it is the single relationship in currency markets that holds almost perfectly at all times and in all weathers.

The forward price is a poor predictor of the spot price. Over long stretches the higher yielding currency has tended to do better than the forward implied, which is the carry trade, and the exits from it are violent and crowded. Spot markets move on expectations about where policy rates are going, which is why a hawkish surprise moves the currency within seconds of the statement release. The mechanics of the meeting are in how the Federal Reserve works, and the pricing of the expected path is in fed funds futures and the dot plot.

Translation, and the earnings nobody earned

A US company runs a European segment. It earns 100 million euros in a year.

At an exchange rate of 1.20 dollars per euro that segment reports $120 million. At 1.05 it reports $105 million. The fall is $105m / $120m - 1 = -12.5%, and not one thing changed in Europe: the same customers bought the same products at the same prices, and the decline exists entirely inside the conversion.

This is why companies publish constant currency growth alongside the reported figures, restating the prior period at current exchange rates so that the operating business can be seen on its own. The adjustment is legitimate. It is also the first place to look when a management team explains a weak quarter, because currency works in the other direction too and the same companies go noticeably quiet about constant currency growth in the years the dollar falls.

The effect compounds up to the index level. A large share of the revenue earned by the biggest US companies comes from outside the country, so a sustained dollar rally quietly trims reported earnings growth across the market while the domestic economy is doing nothing unusual.

Everything the world buys is quoted in dollars

Oil, copper, gold and most of what moves on a ship are priced in dollars wherever they are traded. That convention has a mechanical consequence.

Hold the dollar price of oil at $80 a barrel. At 1.20 dollars per euro, a European buyer pays $80 / 1.20 = 66.67 euros. At 1.05, the same barrel costs $80 / 1.05 = 76.19 euros, which is 14.3% more expensive in the buyer’s own money while the dollar quote sat perfectly still. Demand outside the United States softens. Over time that tends to pull the dollar price down, which is the usual explanation for the loose inverse relationship between the dollar and commodity indexes.

Loose is the operative word. A supply shock overwhelms the currency channel completely, and there have been long periods when the dollar and oil rose together. Test how any two of these actually moved with the correlation matrix before building anything on the assumption.

Dollar debt held by people who do not earn dollars

Here the currency stops being a market curiosity. It becomes a financial stability question.

A company in an emerging market borrows $100 million. The local currency trades at 20 to the dollar on the day the loan is drawn, so the debt is 2 billion units of local money. The currency then weakens to 25 per dollar. The debt is now 2.5 billion in local terms, an increase of 25%, and the interest payments have climbed in the same proportion, while the company’s revenue is still being collected in the currency that just fell.

Hedged and unhedged international funds

Own an overseas index fund and your return has two parts stacked on top of each other. The local market does what it does. The currency then converts it.

Say a European index rises 8% in euro terms and the euro falls 5% against the dollar over the same year. A US holder of an unhedged fund earns 1.08 x 0.95 - 1 = 2.6%. Had the euro risen 5% instead, the same 8% would have arrived as 1.08 x 1.05 - 1 = 13.4%. One local return, two answers about eleven percentage points apart.

A hedged share class sells the currency forward and removes most of that. Two things follow, and the second gets missed constantly. Hedging cuts volatility a great deal in a bond fund, where currency swings are large beside the underlying returns, and much less in an equity fund, where stock volatility dwarfs currency volatility anyway. And the hedge earns or pays the interest rate differential from the forward calculation above, so hedging foreign assets back into dollars adds to your return when US rates sit above foreign rates and subtracts when they sit below.

Neither version is the safe one. The unhedged fund gives you a second, uncorrelated source of return that sometimes helps, and the argument for holding it is closer to the argument for diversification than to any forecast about exchange rates.

Where the story stops working

In a genuine scramble for cash the dollar rises whatever the rate differentials say, because dollars are what the world’s short-term funding is written in and everybody who owes any of it needs them on the same afternoon. March 2020 demonstrated it plainly: a global risk event, a collapse in American growth expectations, and a sharply higher dollar anyway.

Over horizons measured in decades, currencies do drift toward the levels that equalise the cost of a comparable basket of goods across countries, and prices are the reason, which connects back to inflation and CPI explained. Over horizons measured in quarters, that idea explains close to nothing.

The last caution is the index itself. Six currencies, weights frozen since 1999, and a euro share above half. The dollar can weaken on that screen while strengthening against the currencies that matter for import prices and factory competition, so check which measure a commentary is using before accepting the conclusion, and see how the rate story feeds equities in how interest rates affect stocks.